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Eurozone Debt Crisis Part 4: A Comedy of Policy Missteps; the Drama of Bailouts; the Tragedy of Capital Controls.

EU flag square (Photo credit: Wikipedia)

Let us accept the premise that there is no viable alternative to the EMU, and therefore, Germany and France will do their utmost to save it. This raises several questions:

What must they do to save it? Do they even have the authority to do so?

Do they have the money to save it?

What will be the effects of the attempt to save it? And what will be the collateral damage if any?

What will it mean to the US and the rest of the world as the Franco-German Alliance execute their plans?

A Fiscal Union is the Best Way to Save the EMU; But that is not Realistic in the Short-term.

In a natural Sovereign Nation, the Federal Government is the final back-stop to most sub-national debtors. In a crisis, if it chooses to or is compelled to, the Government, the fiscal right hand of economic policy, will either dig into Balance Sheet surpluses if there are any, or issue debt through its Treasury Department to bailout the troubled institution. It will then disburse that largesse through its Central Bank, the monetary left hand of economic policy through what is called open market operations. After the threat has abated, it behooves the Government to reorganize its own balance sheet to return to a steady-state basis, either in terms of re-building national equity or paying down debt. The EMU, however, is not a naturally constituted nation. There is no “Federal Government” or unified fiscal arm. The EMU is an artificial construct, bound by specific treaties and subject to endless negotiation. The only centralized institution that was agreed upon in 1999 was the creation of the European Central Bank, a central monetary authority. So the process of rescuing member nations from their own stupidity is both a convoluted process, and a thankless one. Convoluted, because the Rescuer has no control over the finances of the one who is Rescued. Thankless, because the Rescued nation has no affinity or loyalty to the Rescuer.

Shouldn’t crises of this magnitude force nations to unite? Keep in mind that the EU has been negotiating without success for the last 50 years on the issue of Fiscal Unity, to no success. If they couldn’t agree when things were relatively stable, it seems unlikely that agreement will occur in crises. Exacerbating this would be the extremely high cost that both sides would pay economically. Fiscally vulnerable nations would face excruciating budget cuts to right-size their economies. A 50% unemployment rate in Greece is probably chicken-feed to it. For the Rescuer nations, it would be a repeat of the deficit financing that Germany faced in the 1990s, multiplied many times. Yet, if the EMU is indeed a political necessity, then there is no alternative to Fiscal Union. How do we get from the hodge-podge of today’s system to a centrally governed fiscal union? Painfully and slowly. The Bail out mechanism will remain the short term fix to keep the system afloat, and the multi-year transition to a Fiscal Union will have to occur within the relative stability of a Controlled Capital Regime – which means suspending the free convertibility of the Euro.

Do the Germans and French have the authority to force this union? Over time, yes. The will of the pocket book will overpower that of the Ballot Box. There is a smart folk saying in investing, “Anyone can make money, if he doesn’t go bankrupt first”. Greece is bankrupt.

Balance Sheets are Stretched, Yet there is More Fire Power than Expected in the German Arsenal.

“But can they afford it?”, you demand. You point to various discussions in the media that highlight impossible levels of national debt. “They don’t have the capacity to keep the system afloat. Your thesis might be valid in theory, but there’s not enough money for it to be practical.” You remember your investment portfolio, and your company’s Euro exposure, and start to sweat, “It’s impossible! We are approaching another “Lehman” moment! Help! Where’s the Bar?”. Take a deep breath; get yourself a drink, and look at the table below. Anyone who says Balance Sheets aren’t stretched is delusional. Yet, things mightn’t be as bad as painted if we can move fairly quickly from bailouts to a regulated Capital system. There are definitely risks, but we will discuss those later.

How much debt can a sovereign nation carry on a sustainable basis? The answer to that question determines how much wiggle room France and Germany have in keeping the Eurozone solvent. In Corporate Finance, a company’s total debt is analyzed relative to the predictability and quality of its earnings, and value of its underlying assets. The more profitable the business model, and the more predictable the cash flows, the higher is the leverage that a company can sustain. Additionally, if a company is perceived to own very valuable assets, that might enhance borrowing capacity too. Governments are fundamentally not good businesses to invest in. Governments are run by politicians, resulting in a high degree of capital inefficiency. Governments are torn by competing obligations often at the expense of creditors. Lastly they are highly cyclical. So why do investors lend to a Government at all? They lend to a Government on the backs of a vibrant private sector, if the Borrower nation can prove (a) a viable and stable political environment, and (b) a fairly predictable, and sustainable tax base. In fact it is when a country like Greece crowds out its private sector, falls into political anarchy, and can’t collect on its taxes that it is shut out of the debt markets.

A good sovereign credit then seems akin to a Regulated Utility, that proves its credit worthiness by the stability and predictability of its underlying rate base. Consider the leverage of Utilities publicly traded in the United States, supposedly the safest credit in the world. Average leverage for this group was 4.0x on latest data available with a range from 0x – 7.3x. Applying this metric to the Comparative Table on National Leverage, we see that on current estimates Germany has a Gross Debt to GDP of 3.6x, to France’s 4.2x. Incidentally, the United States is comparable to Germany at 3.8x, and Good Ol’ Greece is at a heady 7.5x.

A couple comments on this table, worth noting:

In choosing the unfunded Present Value of Pension and Medical obligations, I wanted to avoid some doomsday scenarios that value the obligations into perpetuity. Last I looked, except for some leaseholds, few debts are ever indefinitely due. Borrowings are raised to be retired or restructured. Hence the Chief Accountability Office’s estimate for the United States that is over a 70 year period, and the same for the Final Report by the EUROSTAT office for the EMU seemed most appropriate. However, neither of these agencies had corresponding data for Ireland, Italy, Portugal and Greece. For those countries, therefore, I did take Jagadeesh Gokhale’s fine report from 2009 titled, “Measuring the Unfunded Obligations of European Countries”. His report did value the obligations into perpetuity, based on several good arguments that you can read through the hyperlink. For my purposes, I haircut them in proportion to the difference between EUROSTAT and Gokhale’s estimates differed for Germany and France. A rough-cut for sure, but directionally preserving his analysis. In the case of the United States, the Accountability Office’s exemplary Financial Report also from 2009 was a great resource. It is not clear how much the Health Care Act of 2010 affects that number, since some aspects of Medicare are impacted by it. So I have left that part of the debate out of the calculations. I do not think that it changes the final analysis.

Since a Central Bank’s open market operations are funded by the Treasury department, I assume that all the massive expansion that we have seen in Central Bank Balance Sheets globally, are fully reflected in the Gross Government Debt number. However, the Target 2 system is a processing platform that funds outstanding credit lines. It is through that system that Germany is effectively funding the day to day operations of the Greece, for example. Hence, I adjust German claims on the Target 2 system against their indebtedness, and I add it to Greece’s debt load. Lastly, the contingent liabilities under the European Financial Stability Fund/European Stability Mechanism have not been fully called, and therefore I gross it up into the debt structure of all member states. Greece, Portugal and Ireland that have been the recipients of bailouts are exempt from contributing to the mechanism and therefore see no impact from that obligation.

At 3.6x, Germany is below the average leverage of a regulated Utility. France, by comparison is already above the average, but not by much. What the table also shows is that Debt estimates have to be off by 50% for leverage to rise materially into the 5.4-5.5x range. That represents an additional capacity of $6 trillion. Given that German obligations under EFSF are currently only about $211billion, and its advances under the Target 2 system are around $640 billion, this represents significant debt capacity. One could conceivably have Germany take on all the debt of Portugal, Greece and Ireland and still only have used about 2/3rd of its incremental debt capacity. This assumes of course that interest rates do not change materially. However, consider that through this current debacle, without any clear indication of how the monies will be used, the international debt markets most recently allowed Germany to issue debt at 0% interest. Essentially, investors gave Germany money to hold in trust! If Germany accompanied a wholesale bailout of peripheral nations along with a strong roadmap to Full Fiscal Union, it might actually be able to raise the additional debt without significant penalty.

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Its obvious. All the european theater has to rewrite their currenies. Yes including Germany. Those countries that can’t manage their internal budjets will have it managed for them. Training will be provided for those specific countries who need management help so they can eventually look after themselves. Gold standard? That would probably be best, but is optional. REAL value must be established behind every countries currency, not just paper. This value is the GDP not smoke and mirrors. Will this transition hurt? yup you bet. Riots, civil unrest and so on. Alternate REAL suggestions are welcome.

Your “solution” is too simplistic and doomed to fail. I love your comment that …”Those countries that can’t manage their internal budjets will have it managed for them.” By who? Who’s going to pay the managers? And you’re only addressing the European theater? What about the United States? Who are you going to have manage OUR budget?

Hey bwshook: thanks for your comment. I do think that the solution is hardly simplistic. it is just the only way forward as far as I can see. Happy to be corrected because capital controls would be both difficult to impose, and capital inefficient. I agree that there is much to address in the US as well. Look out for my post for July 4th. There’s much to talk about :)

Laurel and Hardy bumping into one another wondering what direction to go in next. No it will be a crash and burn because of lack of mature discernment and correct active action. The cost of “doing the right thing” would come with too high of a price with the European people. This is our once every 100 years depression. We’re supposed to have this one. The fix will be unpleasant as it will involve some pain. I always wondered if everyone just cancelled all the debts what shape would we be in? We’re playing a sick version of financial musical chairs. The industrious shall survive.

Hi Quantum and thanks for your engagement on this topic. I hate to say this, but I think that’s what happens in the end, namely, as i say in Part 4, “debts are raised either to be retired or restructured”. If we totaled up the % of debt issued globally that is ultimately forgiven, it’s probably pretty darn high over a century. I dont have the numbers, but if you look at the debt issued in the Latin American crisis, it would be interesting to tabulate % of original debt issued in 1960-70s that was ultimately redeemed. It’s always the same, politicians will write-off unpleasant stuff, just like companies take “restructuring charges”. So called one-time charges to wipe the slate clean and start the madness all over again. I do hope your last statement is true. That would be some victory. :)

Yes, writing off the debt is also obvious. Question is, who is taking the loss on the bad loans? Germany? Other world leaders? When loans are forgiven does the lender then expect certain benifits with that country? My main concern is to stop future bad financial decissions. The lenders (and the people within that country), should expect good economic choices, not the usual downward spiral over time. This is why I suggested guidance for that countries budget and future choices. To bring this into a better light, reflect on a personnal bankruptcy and what happens after this option is chosen. Yes this is a country were talking about, but there has to be some ownership for fumbling the financial ball. not a slap on the wrist and a stern talking too.

Hey Quantum: who do you think is taking the loss? First the private bondholders – pension funds and other did. Then the loans were moved to the sovereigns. WHen they default it is the IMF and thru them the taxpayers of almost all countries that contribute to it ie the US + the Germans for sure because they’ve funded the ECB. Payback? If the loan forgiveness comes with a clear path to Fiscal Union then the payback MIGHT be that future bubbles are avoided. But when did you hear before? History mightnt repeat, it will rhyme. And I agree with you on the last point. As the world gets older, we cannot treat countries different from corporations. The only reason a country is different is that politically it remains in existence, so you can’t have a Chapter 7. But a Chapter 11 would include a merger into a stronger corp. That’s the fiscal union. :)

You wrote in Part 2 that “Alabama and New York can’t see eye to eye on most issues and they are part of one country. Are you seriously expecting Continental Europe, with its thousand year history of strife and warfare to cuddle up to each other?”. In Part 3 you said you were wrong about that. What was wrong with this statement? It seemed like only yesterday that a journalist was interviewing a Serbian after a particular battle, asked ‘what happened?” and the Serbian starts talking about, “well in 1448, their was a battle between the Kingdom of Hungary and the Ottoman Turks….” I may have the details wrong, but the point is clear: many European tribes have LONG memories, and continue to fight battles which ended sometimes centuries ago. I have often thought that one of the many reasons Europeans hate Americans is we DON’T have that long memory, we don’t carry on blood feuds for centuries (Hatfields and McCoys’ feud standing out BECAUSE it’s so extraordinary for America). This distrust Europeans have of other Europeans might not be as strong everywhere in Europe, but it would seem impossible to discount so easily as a reason for non cooperation in the face of obvious benefits of cooperation.

Hey Prost, thanks for your comments. Thanks for pointing that comment out. There really isnt anything wrong with that comment, other than the fact that while i was fairly well versed with medieval and imperial european history, i had somehow completely missed the reality of the post WW2 period. It isn’t to say that there aren’t all those undercurrents. After all, I bet the medieval gene in Mitterrand quite liked screwing around with Kohl :). However, i think the powers that have the money, or at least the borrowing capacity (LOL) in Europe, see a geo-political imperative in staying united. I hadnt appreciated that, and therefore in writing Part 3 i am sharing with you my own evolution in thinking about that region. Many of recent comments by Merkel, ECB and EC folk make more sense in that context. And I do think that in the final analysis that is what is underpinning their thinking. i think italy and spain also recognize that – hence the commentary from the leaders of those countries. And believe me, I take their commentary with a pinch of salt and pepper. Yet, there is a common thread and that thread makes more sense to me now…